key question answers macro

18
CHAPTER ONE APPENDIX 1-1 Use the economic perspective to explain why someone who is normally a light eater at a standard restaurant may become somewhat of a glutton at a buffet-style restaurant which charges a single price for all you can eat. This behavior can be explained in terms of marginal costs and marginal benefits. At a standard restaurant, items are priced individually — they have a positive marginal cost. If you order more, it will cost you more. You order until the marginal benefit from the extra food no longer exceeds the marginal cost. At a buffet you pay a flat fee no matter how much you eat. Once the fee is paid, additional food items have a zero marginal cost.You therefore continue to eat until your marginal benefit becomes zero. 1-5 Explain in detail the interrelationships between economic facts, theory, and policy. Critically evaluate this statement: “The trouble with economic theory is that it is not practical. It is de- tached from the real world.” Economic theory consists of factually supported general- izations about economic behavior that can be used to formu- late economic policies. Economic theory enables policymakers to formulate economic policies that are relevant to real-world goals and problems that are based upon carefully observed facts. 1-7 Indicate whether each of the following statements applies to microeconomics or macroeconomics: (a), (d), and (f) are macro; (b), (c), and (e) are micro. 1-8 Identify each of the following as either a positive or a nor- mative statement: a. The high temperature today was 89 degrees. b. It was too hot today. c. Other things being equal, higher interest rates reduce the total amount of borrowing. d. Interest rates are too high. (a) and (c) are positive; (b) and (d) are normative. 1-9 Explain and give an illustration of (a) the fallacy of compo- sition; and (b) the “after this, therefore because of this” fallacy. Why are cause-and-effect relationships difficult to isolate in the social sciences? (a) The fallacy of composition is the mistake of believing that something true for an individual part is necessarily true for the whole. Example: A single auto producer can increase its profits by lowering its price and taking business away from its competitors. But matched price cuts by all auto manufactur- ers will not necessarily yield higher industry profits. (b) The “after this, therefore because of this” fallacy is incor- rectly reasoning that when one event precedes another, the first even necessarily caused the second. Example: Interest rates rise, followed by an increase in the rate of inflation, leading to the erroneous conclusion that the rise in interest rates caused the inflation. Actually higher interest rates slow inflation. Cause-and-effect relationships are difficult to isolate because “other things” are continually changing. CHAPTER TWO 2-5 Why is the problem of unemployment a part of the subject matter of economics? Distinguish between allocative efficiency and productive efficiency. Give an illustration of achieving pro- ductive, but not allocative, efficiency. Economics deals with the “limited resources—unlimited wants” problem. Unemployment represents valuable resources that could have been used to produce more goods and services—to meet more wants and ease the economizing problem. Allocative efficiency means that resources are being used to produce the goods and services most wanted by society. The economy is then located at the optimal point on its production possibilities curve where marginal benefit equals marginal cost for each good. Productive efficiency means the least costly pro- duction techniques are being used to produce wanted goods and services. Example: manual typewriters produced using the least- cost techniques but for which there is no demand. 2-6 Here is a production possibilities table for war goods and civilian goods: Type of Production Production Alternatives A B C D E Automobiles 0 2 4 6 8 Rockets 30 27 21 12 0 a. Show these data graphically. Upon what specific as- sumptions is this production possibilities curve based? b. If the economy is at point C, what is the cost of one more automobile? One more rocket? Explain how this curve reflects increasing opportunity costs. c. What must the economy do to operate at some point on the production possibilities curve? (a) See curve EDCBA. The assumptions are full employ- ment and productive efficiency, fixed supplies of re- sources, and fixed technology. 279 Answers to Key Questions 8 E D C G H PPC 2 PPC 3 PPC 1 B A 6 4 2 0 12 21 27 30 Automobiles Rockets Question 2-6

Upload: krenarabazi

Post on 10-Apr-2015

4.515 views

Category:

Documents


8 download

TRANSCRIPT

CHAPTER ONE APPENDIX

1-1 Use the economic perspective to explain why someone whois normally a light eater at a standard restaurant may becomesomewhat of a glutton at a buffet-style restaurant which chargesa single price for all you can eat.

This behavior can be explained in terms of marginal costsand marginal benefits. At a standard restaurant, items are pricedindividually — they have a positive marginal cost. If you ordermore, it will cost you more. You order until the marginal benefitfrom the extra food no longer exceeds the marginal cost. At abuffet you pay a flat fee no matter how much you eat. Once thefee is paid, additional food items have a zero marginal cost. Youtherefore continue to eat until your marginal benefit becomeszero.

1-5 Explain in detail the interrelationships between economicfacts, theory, and policy. Critically evaluate this statement: “Thetrouble with economic theory is that it is not practical. It is de-tached from the real world.”

Economic theory consists of factually supported general-izations about economic behavior that can be used to formu-late economic policies. Economic theory enables policymakersto formulate economic policies that are relevant to real-worldgoals and problems that are based upon carefully observedfacts.

1-7 Indicate whether each of the following statements appliesto microeconomics or macroeconomics:(a), (d), and (f) are macro; (b), (c), and (e) are micro.

1-8 Identify each of the following as either a positive or a nor-mative statement:

a. The high temperature today was 89 degrees.b. It was too hot today.c. Other things being equal, higher interest rates reduce thetotal amount of borrowing.d. Interest rates are too high.(a) and (c) are positive; (b) and (d) are normative.

1-9 Explain and give an illustration of (a) the fallacy of compo-sition; and (b) the “after this, therefore because of this” fallacy.Why are cause-and-effect relationships difficult to isolate in thesocial sciences?

(a) The fallacy of composition is the mistake of believing thatsomething true for an individual part is necessarily true forthe whole. Example: A single auto producer can increase itsprofits by lowering its price and taking business away from itscompetitors. But matched price cuts by all auto manufactur-ers will not necessarily yield higher industry profits.(b) The “after this, therefore because of this” fallacy is incor-rectly reasoning that when one event precedes another, thefirst even necessarily caused the second. Example: Interestrates rise, followed by an increase in the rate of inflation, leading to the erroneous conclusion that the rise in interestrates caused the inflation. Actually higher interest rates slowinflation.

Cause-and-effect relationships are difficult to isolate because “other things” are continually changing.

CHAPTER TWO

2-5 Why is the problem of unemployment a part of the subjectmatter of economics? Distinguish between allocative efficiencyand productive efficiency. Give an illustration of achieving pro-ductive, but not allocative, efficiency.

Economics deals with the “limited resources—unlimitedwants” problem. Unemployment represents valuable resourcesthat could have been used to produce more goods and services—to meet more wants and ease the economizingproblem.

Allocative efficiency means that resources are being used toproduce the goods and services most wanted by society. Theeconomy is then located at the optimal point on its productionpossibilities curve where marginal benefit equals marginal costfor each good. Productive efficiency means the least costly pro-duction techniques are being used to produce wanted goods andservices. Example: manual typewriters produced using the least-cost techniques but for which there is no demand.

2-6 Here is a production possibilities table for war goods andcivilian goods:

Type of Production Production Alternatives

A B C D E

Automobiles 0 2 4 6 8Rockets 30 27 21 12 0

a. Show these data graphically. Upon what specific as-sumptions is this production possibilities curve based?b. If the economy is at point C, what is the cost of one moreautomobile? One more rocket? Explain how this curve reflectsincreasing opportunity costs.c. What must the economy do to operate at some point onthe production possibilities curve?

(a) See curve EDCBA. The assumptions are full employ-ment and productive efficiency, fixed supplies of re-sources, and fixed technology.

279

Answers to Key Questions

8E

D

CG

H

PPC2

PPC3

PPC1

B

A

6

4

2

0 12 21 27 30

Aut

omob

iles

Rockets

Question 2-6

waL63791_Ans_279-296 6/18/01 2:51 PM Page 279

280 ANSWERS TO KEY QUESTIONS

(b) 4.5 rockets; .33 automobiles, as determined from thetable. Increasing opportunity costs are reflected in theconcave-from-the-origin shape of the curve. This meansthe economy must give up larger and larger amounts ofrockets to get constant added amounts of automobiles—and vice versa.(c) It must obtain full employment and productiveefficiency.

2-9 Specify and explain the shapes of the marginal-benefit andmarginal-cost curves and use these curves to determine the op-timal allocation of resources to a particular product. If current out-put is such that marginal cost exceeds marginal benefit, shouldmore or less resources be allocated to this product? Explain.

The marginal benefit curve is downward sloping, MB falls asmore of a product is consumed because additional units of agood yield less satisfaction than previous units.The marginal costcurve is upward sloping, MC increases as more of a product isproduced since additional units require the use of increasinglyunsuitable resources. The optimal amount of a particular prod-uct occurs where MB equals MC. If MC exceeds MB, fewer re-sources should be allocated to this use. The resources are morevaluable in some alternative use (as reflected in the higher MC)than in this use (as reflected in the lower MB).

2-10 Label point G inside the production possibilities curve youhave drawn for question 6. What does it indicate? Label point Houtside the curve. What does this point indicate? What must oc-cur before the economy can attain the level of production indi-cated by point H?

G indicated unemployment, productive inefficiency, or both. His at present unattainable. Economic growth—through more in-puts, better inputs, improved technology—must be achieved toattain H.

2-11 Referring again to question 6, suppose improvement oc-curs in the technology of producing rockets but not in the pro-duction of automobiles. Draw the new production possibilitiescurve. Now assume that a technological advance occurs in pro-ducing automobiles but not in producing rockets. Draw the newproduction possibilities curve. Now draw a production possibili-ties curve that reflects technological improvement in the produc-tion of both products.

See the graph for question 2-6. PPC1 shows improved rockettechnology. PPC2 shows improved auto technology. PPC3 showsimproved technology in producing both products.

CHAPTER THREE

3-2 What effect will each of the following have on the demandfor product B?

a. Product B becomes more fashionable.b. The price of substitute product C falls.c. Income declines and product B is an inferior good.d. Consumers anticipate the price of B will be lower in thenear future.e. The price of complementary product D falls.f. Foreign tariff barriers on B are eliminated.

Demand increases in (a), (c), (e), and (f); decreases in (b) and(d).

3-5 What effect will each of the following have on the supply ofproduct B?

a. A technological advance in the methods of producing B.b. A decline in the number of firms in industry B.c. An increase in the price of resources required in the pro-duction of B.d. The expectation that equilibrium price of B will be lowerin the future than it is currently.

e. A decline in the price of product A, a good whose pro-duction requires substantially the same techniques as doesthe production of B.f. The levying of a specific sales tax upon B.g. The granting of a 50-cent per unit subsidy for each unit ofB produced.

Supply increases in (a), (d), (e), and (g); decreases in (b), (c),and (f).

3-7 Suppose the total demand for wheat and the total supplyof wheat per month in the Kansas City grain market are as fol-lows:

Thousands Price Thousand Surplus (�)of bushels per of bushels or demanded bushel supplied shortage (�)

85 $3.40 72

80 3.70 73

75 4.00 75

70 4.30 77

65 4.60 79

60 4.90 81 _____

a. What will be the market or equilibrium price? What is theequilibrium quantity? Using the surplus-shortage column, ex-plain why your answers are correct.b. Graph the demand for wheat and the supply of wheat. Besure to label the axes of your graph correctly. Label equilib-rium price “P” and the equilibrium quantity “Q.”c. Why will $3.40 not be the equilibrium price in this market?Why not $4.90? “Surpluses drive prices up; shortages drivethem down.” Do you agree?d. Now suppose that the government establishes a ceilingprice of, say, $3.70 for wheat. Explain carefully the effects ofthis ceiling price. Demonstrate your answer graphically. Whatmight prompt the government to establish a ceiling price?

Data from top to bottom: �13; �7; 0; �7; �14; and �21.

$4.90D

P

S Q

S

D

4.60

4.30

4.00

3.70

3.40

0 60 65 70 75 80 85

Pric

e pe

r bu

shel

Quantity (thousands of bushels)

Equilibrium: P � $4.00Q � 75

Shortage at$3.70 priceceiling

Question 3-7

(a) Pe � $4.00; Qe � 75,000. Equilibrium occurs where thereis neither a shortage nor surplus of wheat. At the immediatelylower price of $3.70, there is a shortage of 7,000 bushels. Atthe immediately higher price of $4.30, there is a surplus of7,000 bushels. (See graph top of next page.)(b) Quantity (thousands) of bushels.(c) Because at $3.40 there will be a 13,000 bushel shortagewhich will drive the price up. Because at $4.90 there will bea 21,000 bushel surplus which will drive the price down. Quo-tation is incorrect; just the opposite is true.

waL63791_Ans_279-296 6/18/01 2:51 PM Page 280

(b) Adopt technique 4 because its cost is now lowest at $32.(c) Technique 1 because its cost is now lowest at $27.50(d) The statement is logical. Increasing scarcity causes pricesto rise. Firms ignoring higher resource prices will becomehigh-cost producers and be competed out of business by firmsswitching to the less expensive inputs. The market systemforces producers to conserve on the use of highly scarce re-sources. Question 8c confirms this: Technique 1 was adoptedbecause labor had become less expensive.

4-9 Some large hardware stores such as Home Depot boastof carrying as many as 20,000 different products in each store.What motivated the producers of those products—everythingfrom screwdrivers to ladders to water heaters—to make themand offer them for sale? How did producers decide on the bestcombinations of resources to use? Who made these resourcesavailable, and why? Who decides whether these particular hard-ware products should continue to get produced and offered forsale?

The quest for profit led firms to produce these goods. Pro-ducers looked for and found the least-cost combination of re-sources in producing their output. Resource suppliers, seekingincome, made these resources available. Consumers, throughtheir dollar votes, ultimately decide on what will continue to beproduced.

CHAPTER FIVE

5-2 Assume that the five residents of Econoville receive in-comes of $50, $75, $125, $250, and $500. Present the resultingpersonal distribution of income as a graph similar to Figure 5-2.Compare the incomes of the lowest and highest fifth of the in-come receivers. The distribution of income is quite unequal. Thehighest 20 percent of the residents receive 10 times more in-come than the lowest 20 percent.

ANSWERS TO KEY QUESTIONS 281

(d) A $3.70 ceiling causes a persistent shortage. This prod-uct may be a necessity and the government is concerned thatsome consumers might not being able to afford it.

3-8 How will each of the following changes in demand and/orsupply affect equilibrium price and equilibrium quantity in a com-petitive market; that is, do price and quantity rise, fall, remain un-changed, or are the answers indeterminate, depending on themagnitudes of the shifts in supply and demand? You should relyon a supply and demand diagram to verify answers.

a. Supply decreases and demand remains constant.b. Demand decreases and supply remains constant.c. Supply increases and demand is constant.d. Demand increases and supply increases.e. Demand increases and supply is constant.f. Supply increases and demand decreases.g. Demand increases and supply decreases.h. Demand decreases and supply decreases.(a) Price up; quantity down;(b) Price down; quantity down;(c) Price down; quantity up;(d) Price indeterminate; quantity up;(e) Price up; quantity up;(f) Price down; quantity indeterminate;(g) Price up, quantity indeterminate;(h) Price indeterminate and quantity down.

CHAPTER FOUR

4-7 Assume that a business firm finds that its profits will be atmaximum when it produces $40 worth of product A. Supposealso that each of the three techniques shown in the followingtable will produce the desired output.

Resource Units Required

Price per unit Technique Technique TechniqueResource of resource No. 1 No. 2 No. 3

Labor $3 5 2 3Land 4 2 4 2Capital 2 2 4 5Entrepreneurialability 2 4 2 4

a. With the resource prices shown, which technique will thefirm choose? Why? Will production entail profits or losses?Will the industry expand or contract? When is a new equilib-rium output achieved?b. Assume now that a new technique, technique No. 4, is de-veloped. It entails the use of 2 units of labor, 2 of land, 6 ofcapital, and 3 of entrepreneurial ability. Given the resourceprices in the table, will the firm adopt the new technique? Ex-plain your answers.c. Suppose now that an increase in labor supply causes theprice of labor to fall to $1.50 per unit, all other resource pricesbeing unchanged. Which technique will the producer nowchoose? Explain.d. “The market system causes the economy to conservemost in the use of those resources which are particularlyscarce in supply. Resources that are scarcest relative to thedemand for them have the highest prices. As a result, pro-ducers use these resources as sparingly as is possible.” Eval-uate this statement. Does your answer to part c, above, bearout this contention? Explain.(a) Technique 2. Because it produces the output with leastcost ($34 compared to $35 each for the other two). Economicprofit will be $6 (� 40 � $34), which will cause the industryto expand. Expansion will continue until prices decline towhere total revenue is $34 (equal to total cost).

0

10

20

30

40

50

Lowest20%

Second20%

Middle20%

Fourth20%

Highest20%

5.07.5

12.5

25.0

50.0

Income group

Pe

rso

na

l in

co

me

re

ce

ive

d (

pe

rce

nt) Question 5-2

5-4 What are the major legal forms of business organization?Briefly state the advantages and disadvantages of each. How doyou account for the dominant role of corporations in the U.S.economy?

The legal forms of business organizations are: sole propri-etorship, partnership, and corporation.

Proprietorship advantages: easy to start and provides maxi-mum freedom for the proprietor to do what she/he thinks best.

waL63791_Ans_279-296 6/18/01 2:51 PM Page 281

Proprietorship disadvantages: limited financial resources; theowner must be a Jack-or-Jill-of-all-trades; unlimited liability.

Partnership advantages: easy to organize; greater special-ization of management; and greater financial resources. Disad-vantages: financial resources are still limited; unlimited liability;possibility of disagreement among the partners; and precariouscontinuity.

Corporation advantages: can raise large amounts of moneyby issuing stocks and bonds; limited liability; continuity.

Corporation disadvantages: red tape and expense in incor-porating; potential for abuse of stockholder and bondholder funds;double taxation of profits; separation of ownership and control.

The dominant role of corporations stems from the advantagescited, particularly unlimited liability and the ability to raise money.

5-9 What are the basic characteristics of public goods? Explainthe significance of the exclusion principle. By what means doesgovernment provide public goods?

Public goods are indivisible (they are produced in such largeunits that they cannot be sold to individuals) and the exclusion principle does not apply to them (once the goods are producednobody—including free riders—can be excluded from the goods’benefits). The free-rider problem explains the significance of theexclusion principle. The exclusion principle separates goods and services which private firms will supply (because those who do notpay for them can be excluded from their benefits) and goods andservices which government must supply (because people can ob-tain the benefits without paying). Government must levy taxes toget revenues to pay for public goods.

5-10 Draw a production possibilities curve with public goods onthe vertical axis and private goods on the horizontal axis. As-suming the economy is initially operating on the curve, indicatethe means by which the production of public goods might be in-creased. How might the output of public goods be increased ifthe economy is initially functioning at a point inside the curve?

On the curve, the only way to obtain more public goods is toreduce the production of private goods (from C to B).

An economy operating inside the curve can expand the pro-duction of public goods without sacrificing private goods (say,from A to B) by making use of unemployed resources.

CHAPTER SIX

6-4 The following are production possibilities tables for SouthKorea and the United States. Assume that before specializationand trade the optimal product-mix for South Korea is alternativeB and for the United States alternative U.F

South Korea’s production possibilities

Product A B C D E F

Radios (in 1000s) 30 24 18 12 6 0

chemicals (tons) 0 6 12 18 24 30

U.S. production possibilities

Product R S T U V W

Radios (in 1000s) 10 8 6 4 2 0

chemicals (tons) 0 4 8 12 16 20

a. Are comparative cost conditions such that the two areasshould specialize? If so, what product should each produce?b. What is the total gain in radio and chemical output that re-sults from this specialization?c. What are the limits of the terms of trade? Suppose actualterms of trade are 1 unit of radios for 1-1�2 units of chemi-cals and that 4 units of radios are exchanged for 6 units ofchemicals. What are the gains from specialization and tradefor each area?d. Can you conclude from this illustration that specializationaccording to comparative advantage results in more efficientuse of world resources? Explain.(a) Yes, because the opportunity cost of radios is less (1R �

1C) in South Korea than in the United States (1R � 2C). SouthKorea should produce radios and the United States shouldproduce chemicals.(b) If they specialize, the United States can produce 20 tonsof chemicals and South Korea can produce 30,000 radios.Before specialization South Korea produced alternative B andthe United States alternative U for a total of 28,000 radios(24,000 � 4,000) and 18 tons of chemicals (6 tons � 12tons). The gain is 2,000 radios and 2 tons of chemicals.(c) The limits of the terms of trade are determined by thecomparative cost conditions in each country before trade:1R � 1C in South Korea and 1R � 2C in the United States.The terms of trade must be somewhere between these tworatios for trade to occur.

If the terms of trade are 1R � 1-1/2C, South Korea wouldend up with 26,000 radios (� 30,000 � 4,000) and 6 tons ofchemicals. The United States would have 4,000 radios and14 tons of chemicals (� 20 � 6). South Korea has gained2,000 radios. The United States has gained 2 tons of chem-icals.(d) Yes, the world is obtaining more output from its fixed re-sources.

6-6 True or false? “U.S. exports create a demand for foreigncurrencies; foreign imports of U.S. goods generate supplies offoreign currencies.” Explain. Would a decline in U.S. consumerincome or a weakening of U.S. preferences for foreign productscause the dollar to depreciate or appreciate? Other things equal,what would be the effects of that depreciation or appreciation onU.S. exports and imports?

The first part of this statement is incorrect. U.S. exports cre-ate a domestic supply of foreign currencies, not a domestic de-mand for them. The second part of the statement is accurate.The foreign demand for dollars (from U.S. exports) generates asupply of foreign currencies to the United States.

A decline in U.S. incomes or a weakening of U.S. preferencesfor foreign goods would reduce U.S. imports, reducing U.S.

282 ANSWERS TO KEY QUESTIONS

B

A

C

Private goods

Pub

lic g

oods

0

Question 5-10

5-15 Suppose in Fiscalville there is no tax on the first $10,000of income, but earnings between $10,000 and $20,000 are taxedat 20 percent and income between $20,000 and $30,000 at 30percent. Any income above $30,000 is taxed at 40 percent. Ifyour income is $50,000, how much in taxes will you pay? De-termine your marginal and average tax rates. Is this a progres-sive tax?

Total tax � $13,000; marginal tax rate � 40% average taxrate � 26%. This is a progressive tax; the average tax rate risesas income goes up.

waL63791_Ans_279-296 6/18/01 2:51 PM Page 282

demand for foreign currencies. These currencies would depreci-ate (the dollar would appreciate). Dollar appreciation means U.S.exports would decline and U.S. imports would increase.

6-10 Identify and state the significance of each of the follow-ing: (a) WTO; (b) EU; (c) euro; and (d) NAFTA. What commonal-ity do they share?

(a) The WTO oversees trade agreements reached by mem-ber nations and arbitrates trade disputes among them. (b) TheEU is a trading bloc of 15 European countries who haveagreed to abolish tariffs and import quotas on most productsand have liberalized the movement of labor and capital withinthe EU. (c) The euro is the common currency that will be usedby 11 of the 15 EU countries. (d) NAFTA is a trade bloc madeup of the United States, Canada, and Mexico whose purposeis to reduce tariffs and other trade barriers among the threecountries.All of the above have the goals of increasing internationaltrade and leading to a better allocation of the world’s resources.

CHAPTER SEVEN

7-3 Why do national income accountants include only finalgoods in measuring GDP for a particular year? Why don’t theyinclude the value of stocks and bonds sold? Why don’t they include the value of used furniture bought and sold?

The dollar value of final goods includes the dollar value of intermediate goods. If intermediate goods were counted, thenmultiple counting would occur. The value of steel (intermediategood) used in autos is included in the price of the auto (the finalproduct).

This value is not included in GDP because such sales andpurchases simply transfer the ownership of existing assets; suchsales and purchases are not themselves (economic) investmentand thus should not be counted as production of final goods andservices. Used furniture was produced in some previous year;it was counted as GDP then. Its resale does not measure newproduction.

7-8 Below is a list of domestic output and national income fig-ures for a given year. All figures are in billions. The questions thatfollow ask you to determine the major national income measuresby both the expenditure and income methods. The results youobtain with the different methods should be the same.

Personal consumption expenditures $245Net foreign factor income earned 4Transfer payments 12Rents 14Consumption of fixed capital (depreciation) 27Social security contributions 20Interest 13Proprietors’ income 33Net exports 11Dividends 16Compensation of employees 223Indirect business taxes 18Undistributed corporate profits 21Personal taxes 26Corporate income taxes 19Corporate profits 56Government purchases 72Net private domestic investment 33Personal saving 20

a. Using the above data, determine GDP and NDP by boththe expenditure and income methods.

b. Now determine NI: first, by making the required additionsand subtractions from GDP; and second, by adding up thetypes of income which comprise NI.c. Adjust NI from (b) as required to obtain PI.d. Adjust PI from part c as required to obtain DI.(a) GDP � $388, NDP � $362;(b) NI � $399;(c) PI � $291;(d) DI � $265.

7-11 Suppose that in 1984 the total output in a single-goodeconomy was 7,000 buckets of chicken. Also suppose that in1984 each bucket of chicken was priced at $10. Finally, assumethat in 1992 the price per bucket of chicken was $16 and that22,000 buckets were purchased. Determine the GDP price indexfor 1984, using 1992 as the base year. By what percentage didthe price level, as measured by this index, rise between 1984and 1992? Use the two methods listed in Table 7-6 to determinereal GDP for 1984 and 1992.

X/100 � $10/$16 � .625 or 62.5 when put in percentage orindex form (.625 � 100)

� .60 or 60% (Easily calculated �

� .6 � 60%)

Method 1: 1992 � (22,000 � $16) � 1.0 � $352,0001984 � ($7,000 � $10) � .625 � $112,000

Method 2: 1992 � 22,000 � $16 � $352,0001984 � 7,000 � $16 � $112,000

7-12 The following table shows nominal GDP and an appro-priate price index for a group of selected years. Compute realGDP. Indicate in each calculation whether you are inflating or de-flating the nominal GDP data.

Normal GDP, Price index Real GDPYear Billions (1996–100) billions

1960 $527.4 22.19 $

1968 911.5 26.29 $

1978 2295.9 48.22 $

1988 4742.5 80.22 $

1988 8790.2 103.22 $

Values for real GDP, top to bottom of the column: $2,376.7 (inflating); $3,467.1 (inflating); $4,761.3 (inflating); $5,911.9 (inflating); $8,516 (deflating).

CHAPTER EIGHT

8-2 Suppose an economy’s real GDP is $30,000 in year 1 and$31,200 in year 2. What is the growth rate of its real GDP? Assume that population was 100 in year 1 and 102 in year 2.What is the growth rate of GDP per capita?

Growth rate of real GDP � 4 percent (� $31,200 � $30,000)/$30,000). GDP per capita in year 1 � $300 (� $30,000/100).GDP per capita in year 2 � $305.88 (� $31,200/102). Growthrate of GDP per capita is 1.96 percent � ($305.88 � $300)/300).

8-4 What are the four phases of the business cycle? How long do business cycles last? How do seasonal variations and

6�10

16 � 10�

10100 � 62.5��

62.5

ANSWERS TO KEY QUESTIONS 283

waL63791_Ans_279-296 6/18/01 2:51 PM Page 283

secular trends complicate measurement of the business cycle?Why does the business cycle affect output and employment incapital goods and consumer durable goods industries more severely than in industries producing nondurables?

The four phases of a typical business cycle, starting at thebottom, are trough, recovery, peak, and recession. As seen inFigure 8-1, the length of a complete cycle varies from about 2to 3 years to as long as 15 years.

Normally there is a pre-Christmas spurt in production andsales and a January slackening. This normal seasonal variationdoes not signal boom or recession. From decade to decade, thelong-term trend (the secular trend) of the U.S. economy has beenupward. A period of no GDP growth thus does not mean that allis normal but that the economy is operating below its trend growthof output.

Because capital goods and durable goods last, purchases canbe postponed. This may happen when a recession is forecast.Capital and durable goods industries therefore suffer large out-put declines during recessions. In contrast, consumers cannotlong postpone the buying of nondurables such as food; thereforerecessions only slightly reduce nondurable output. Also, capitaland durable goods expenditures tend to be “lumpy.” Usually, alarge expenditure is needed to purchase them and this shrinksto zero after purchase is made.

8-6 Use the following data to calculate (a) the size of thelabor force and (b) the official unemployment rate: total popula-tion, 500; population under 16 years of age or institutionalized,120; not in labor force, 150; unemployed, 23; part-time workerslooking for full-time jobs, 10.

Labor force � #230 [� 500 � (120 � 150)]; official unemploy-ment rate � 10% [(23/230) � 100].

8-8 Assume that in a particular year the natural rate of unemployment is 5 percent and the actual rate of unemploymentis 9 percent. Use Okun’s law to determine the size of the GDPgap in percentage-point terms. If the nominal GDP is $500 billion in that year, how much output is being foregone becauseof cyclical unemployment?

GDP gap � 8 percent [�(9 � 5)] � 2; forgone output estimatedat $40 billion (�8% of $500 billion).

8-10 If the price index was 110 last year and is 121 this year,what is this year’s rate of inflation? What is the “rule of 70”? Howlong would it take for the price level to double if inflation persistedat (a) 2, (b) 5, and (c) 10 percent per year?

This year’s rate of inflation is 10% or [(121 � 110)/110] � 100.Dividing 70 by the annual percentage rate of increase of any

variable (for instance, the rate of inflation or population growth)will give the approximate number of years for doubling of the variable.

(a) 35 years (� 70/2); (b) 14 years (� 70/5); (c) 7 years (� 70/10).

CHAPTER NINE

9-5 Complete the accompanying table (top of next column).a. Show the consumption and saving schedules graphically.b. Locate the break-even level of income. How is it possiblefor households to dissave at very low income levels?c. If the proportion of total income consumed (APC) decreases and the proportion saved (APS) increases as in-come rises, explain both verbally and graphically how theMPC and MPS can be constant at various levels of income.

Level ofoutput

and income(GDP � DI) Consumption Saving APC APS MPC MPS

$240 $ $ �4

260 $ 0

280 $ 4

300 $ 8

320 $ 12

340 $ 16

360 $ 20

380 $ 24

400 $ 28

Data for completing the table (top to bottom). Consumption: $244;$260; $276; $292; $308; $324; $340; $356; $372. APC: 1.02; 1.00;.99; .97; .96; .95; .94; .94; .93. APS: � .02; .00; .01; .03; .04; .05;.06; .06; .07. MPC: 80 throughout. MPS: 20 throughout.

(a) See the graphs.

284 ANSWERS TO KEY QUESTIONS

400

380

360

340

320

300

280

260

240

C

0 240 280 320 360 400

45

Con

sum

ptio

n

Real GDP

Question 9-6a

40

20

S

0 240 280 320 360 400

Sav

ing

Real GDP

Question 9-6a

(b) Break-even income � $260. Households dissave borrow-ing or using past savings.(c) Technically, the APC diminishes and the APS increasesbecause the consumption and saving schedules have pos-itive and negative vertical intercepts respectively. (Appen-dix to Chapter 1). MPC and MPS measure changes in con-sumption and saving as income changes; they are theslopes of the consumption and saving schedules. Forstraight-line consumption and saving schedules, theseslopes do not change as the level of income changes; theslopes and thus the MPC and MPS remain constant.

9-7 Assume there are no investment projects in the econ-omy which yield an expected rate of return of 25 percent ormore. But suppose there are $10 billion of investment projectsyielding expected rate of return of between 20 and 25 percent;

waL63791_Ans_279-296 6/18/01 2:51 PM Page 284

another $10 billion yielding between 15 and 20 percent; an-other $10 billion between 10 and 15 percent; and so forth. Cu-mulate these data and present them graphically, putting theexpected rate of net return on the vertical axis and the amountof investment on the horizontal axis. What will be the equilib-rium level of aggregate investment if the real interest rate is(a) 15 percent, (b) 10 percent, and (c) 5 percent? Explain whythis curve is the investment-demand curve.

See the graph below. Aggregate investment: (a) $20 billion;(b) $30 billion; (c) $40 billion. This is the investment-demandcurve because we have applied the rule of undertaking all in-vestment up to the point where the expected rate of return, r,equals the interest rate, i.

unplanned investment to explain adjustments toward equilibriumfrom both the $380 and $300 billion levels of domestic output.

At the $380 billion level of GDP, saving � $24 billion; plannedinvestment � $16 billion (from the question). This deficiency of$8 billion of planned investment causes an unplanned $8 billionincrease in inventories. Actual investment is $24 billion (� $16billion of planned investment plus $8 billion of unplanned inven-tory investment), matching the $24 billion of actual saving.

At the $300 billion level of GDP, saving � $8 billion; plannedinvestment � $16 billion (from the question). This excess of $8billion of planned investment causes an unplanned $8 billion decline in inventories. Actual investment is $8 billion (� $16 bil-lion of planned investment minus $8 billion of unplanned inven-tory disinvestment) matching the actual of $8 billion.

When unplanned investments in inventories occur, as at the$380 billion level of GDP, businesses revise their production plansdownward and GDP falls. When unplanned disinvestments in inventories occur, as at the $300 billion level of GDP; businessesrevise their production plans upward and GDP rises. EquilibriumGDP— in this case, $340 billion—occurs where planned invest-ment equals saving.

Say’s law states that “supply creates its own demand.”People work in order to earn income to and plan to spend the income on output—why else would they work? Basically, theclassical economists would say that the economy will operate atfull employment or on the production possibilities curve becauseincome earned will be recycled or spent on output. Thus thespending flow is continuously recycled in production and earn-ing income. If consumers don’t spend all their income, it wouldbe redirected via saving to investment spending on capitalgoods.

The Keynesian perspective, on the other hand, suggests thatsociety’s savings will not necessarily all be channeled into investment spending. If this occurs, we have a situation in whichaggregate demand is less than potential production. Becauseproducers cannot sell all of the output produced at a full em-ployment level, they will reduce output and employment to meetthe aggregate demand (consumption plus investment) and theequilibrium output will be at a point inside the production possi-bilities curve at less than full employment.

CHAPTER TEN

10-2 What is the multiplier effect? What relationship does theMPC bear to the size of the multiplier? The MPS? What will themultiplier be when the MPS is 0, .4, .6, and 1? When the MPCis 1, .90, .67, .50, and 0? How much of a change in GDP will re-sult if businesses increase their level of investment by $8 billionand the MPC in the economy is .80? If the MPC is .67? Explainthe difference between the simple and the complex multiplier.

The multiplier effect is the magnified increase in equilibriumGDP that occurs when any component of aggregate expendi-tures changes. The greater the MPC (the smaller the MPS), thegreater the multiplier.

MPS � 0, multiplier � infinity; MPS � .4, multiplier � 2.5;MPS � .6, multiplier � 1.67; MPS � 1, multiplier � 1.

MPC � 1; multiplier � infinity; MPC � .9, multiplier � 10;MPC � .67; multiplier � 3; MPC � .5, multiplier � 2; MPC � 0,multiplier � 1.

MPC � .8: Change in GDP � $40 billion (� $8 billion ∞ mul-tiplier of 5); MPC � .67: Change in GDP � $24 billion ($8 billion∞ multiplier of 3). The simple multiplier takes account of only theleakage of saving. The complex multiplier also takes account ofleakages of taxes and imports, making the complex multiplierless than the simple multiplier.

ANSWERS TO KEY QUESTIONS 285

25

20

15

10

5ID

0 10 20 30 40 50

Exp

ecte

d ra

te o

f ret

urns

, r, (

%)

Investment (billions)

Question 9-8a

9-9 Assuming the level of investment is $16 billion and in-dependent of the level of total output, complete the followingtable and determine the equilibrium levels of output and em-ployment which this private closed economy would provide.What are the sizes of the MPC and MPS?

Possible levels Real domesticof employment output (GDP � DI) Consumption Saving

(millions) (billions) (billions) (billions)

40 $240 $244 $

45 260 260 $

50 280 276 $

55 300 292 $

60 320 308 $

65 340 324 $

70 360 340 $

75 380 356 $

80 400 372 $

Saving data for completing the table (top to bottom): $-4; $0; $4;$8; $12; $16; $20; $24; $28.

Equilibrium GDP � $340 billion, determined where (1) ag-gregate expenditures equal GDP (C of $324 billion � I of $16 bil-lion � GDP of $340 billion); or (2) where planned I � S (I of $16billion � S of $16 billion). Equilibrium level of employment � 65million; MCP � .8; MPS � .2.

9-10 Using the consumption and saving data given in question9 and assuming the level of investment is $16 billion, what arethe levels of saving and planned investment at the $380 billionlevel of domestic output? What are the levels of saving and ac-tual investment at that level? What are saving and planned in-vestment at the $300 billion level of domestic output? What arethe levels of saving and actual investment? Use the concept of

waL63791_Ans_279-296 6/18/01 2:51 PM Page 285

10-5 The data in columns 1 and 2 of the table above are for aprivate closed economy.

a. Use columns 1 and 2 to determine the equilibrium GDPfor this hypothetical economy.b. Now open this economy for international trade by includ-ing the export and import figures of columns 3 and 4. Calcu-late net exports and determine the equilibrium GDP for theopen economy. Explain why equilibrium GDP differs from theclosed economy.c. Given the original $20 billion level of exports, what wouldbe the equilibrium GDP if imports were $10 billion greater ateach level of GDP? Or $10 billion less at each level of GDP?What generalization concerning the level of imports and theequilibrium GDP do these examples illustrate?d. What is the size of the multiplier in these examples?(a) Equilibrium GDP for closed economy � $400 billion.(b) Net export data for column 5 (top to bottom); $�10 bil-lion in each space. Aggregate expenditure data for column 6(top to bottom): $230; $270; $310; $350; $390; $430; $470;$510. Equilibrium GDP for the open economy is $350 billion,$50 billion below the $400 billion equilibrium GDP for theclosed economy. The $�10 billion of net exports is a leakagewhich reduces equilibrium GDP by $50 billion.(c) Imports � $40 billion: Aggregate expenditures in the pri-vate open economy would fall by $10 billion at each GDP leveland the new equilibrium GDP would be $300 billion. Imports �

$20 billion: Aggregate expenditures would increase by $10billion; new equilibrium GDP would be $400 billion. Exportsconstant, increases in imports reduce GDP; decreases in im-ports increase GDP.(d) Since every rise of $50 billion in GDP increases aggre-gate expenditures by $40 billion, the MPC is .8 and so themultiplier is 5.

10-8 Refer to columns 1 and 6 of the tabular data for question5. Incorporate government into the table by assuming that it plansto tax and spend $20 billion at each possible level of GDP. Alsoassume that all taxes are personal taxes and that governmentspending does not induce a shift in the private aggregate ex-penditures schedule. Compute and explain the changes in equi-librium GDP caused by the addition of government.

Before G is added, open private sector equilibrium will be at350. The addition of government expenditures of G to our analy-sis raises the aggregate expenditures (C � Ig � Xn � G) sched-ule and increases the equilibrium level of GDP as would an increase in C, 1g, or Xn. Note that changes in government spend-ing are subject to the multiplier effect. Government spending supplements private investment and export spending (Ig � X �

G), increasing the equilibrium GDP to 450.

The addition of $20 billion of government expenditures and$20 billion of personal taxes increases equilibrium GDP from$350 to $370 billion. The $20 billion increase in G raises equi-librium GDP by $100 billion (� $20 billion � the multiplier of 5);the $20 billion increase in T reduces consumption by $16 billionat every level. (� $20 billion x the MPC of .8). This $16 billiondecline in turn reduces equilibrium GDP by $80 billion ($16 billion x multiplier of 5). The net change from including balancedgovernment spending and taxes is $20 billion (� $100 billion �

$80 billion).

10-10 Refer to the accompanying table in answering the ques-tions which follow:

(1) (2) (3)

Possible levels Real domestic Real domesticof employment, output, output,

millions billions billions

90 $500 $520100 550 560110 600 600120 650 640130 700 680

a. If full employment in this economy is 130 million, will therebe an inflationary or recessionary gap? What will be the con-sequence of this gap? By how much would aggregate expenditures in column 3 have to change at each level of GDPto eliminate the inflationary or recessionary gap? Explain.b. Will there be an inflationary or recessionary gap if the full-employment level of output is $500 billion? Explain the con-sequences. By how much would aggregate expenditures incolumn 3 have to change at each level of GDP to eliminatethe inflationary or recessionary gap? Explain.c. Assuming that investment, net exports, and governmentexpenditures do not change with changes in real GDP, whatare the sizes of the MPC, the MPS, and the multiplier?(a) A recessionary gap. Equilibrium GDP is $600 billion, whilefull employment GDP is $700 billion. Employment will be 20million less than at full employment. Aggregate expenditureswould have to increase by $20 billion (� $700 billion � $680billion) at each level of GDP to eliminate the recessionarygap.(b) An inflationary gap. Aggregate expenditures will be ex-cessive, causing demand-pull inflation. Aggregate expendi-tures would have to fall by $20 billion (� $520 billion � $500billion) at each level of GDP to eliminate the inflationary gap.

286 ANSWERS TO KEY QUESTIONS

(1) (2) (3) (4) (5) (6)

Real Aggregatedomestic expenditures Net Aggregate

output private closed exports, expenditures,(GDP�DI) economy, Exports, Imports, private open

billions billions billions billions economy billions

$200 $240 $20 $30 $ $

$250 $280 $20 $30 $ $

$300 $320 $20 $30 $ $

$350 $360 $20 $30 $ $

$400 $400 $20 $30 $ $

$450 $440 $20 $30 $ $

$500 $480 $20 $30 $ $

$550 $520 $20 $30 $____ $____

waL63791_Ans_279-296 6/18/01 2:51 PM Page 286

(c) MPC � .8 (� $40 billion/$50 billion); MPS � .2 (� 1 �.8);multiplier � 5 (� 1/.2).

CHAPTER ELEVEN

11-4 Suppose that aggregate demand and supply for a hypo-thetical economy are as shown:

Amount of Amount ofreal domestic real domestic

output demanded, Price level output supplied,billions (price index) billions

$100 300 $400200 250 400300 200 300400 150 200500 150 100

a. Use these sets of data to graph the aggregate demandand supply curves. What will be the equilbrium price level andlevel of real domestic output in this hypothetical economy? Isthe equilibrium real output also the absolute full-capacity realoutput? Explain.b. Why will a price level of 150 not be an equilibrium pricelevel in this economy? Why not 250?c. Suppose that buyers desire to purchase $200 billion of ex-tra real domestic output at each price level.What factors mightcause this change in aggregate demand? What is the newequilibrium price level and level of real output? Over whichrange of the aggregate supply curve—horizontal, intermedi-ate, or vertical—has equilibrium changed?(a) See the graph. Equilibrium price level � 200. Equilibriumreal output � $300 billion. No, the full-capacity level of GDPis $400 billion, where the AS curve becomes vertical(b) At a price level of 150, real GDP supplied is a maximumof $200 billion, less than the real GDP demanded of $400 bil-lion. The shortage of real output will drive the price level up.At a price level of 250, real GDP supplied is $400 billion,which is more than the real GDP demanded of $200 billion.The surplus of real output will drive down the price level. Equi-librium occurs at the price level at which AS and AD inter-sect.

See the graph. Increases in consumer, investment, gov-ernment, or net export spending might shift the AD curve right-ward. New equilibrium price level � 250. New equilibriumGDP � $400 billion. The intermediate range.

a. What is productivity in this economy?b. What is the per unit cost of production if the price of eachinput is $2?c. Assume that the input price increases from $2 to $3 withno accompanying change in productivity. What is the new perunit cost of production? In what direction did the $1 increasein input price push the aggregate supply curve? What effectwould this shift in aggregate supply have upon the price leveland the level of real output?d. Suppose that the increase in input price does not occurbut instead that productivity increases by 100 percent. Whatwould be the new per unit cost of production? What effectwould this change in per unit production cost have on the aggregate supply curve? What effect would this shift in ag-gregate supply have on the price level and the level of realoutput?

Input Real domesticquantity output

150.0 400112.5 30075.0 200

(a) Productivity � 2.67(� 300/112.5).(b) Pre-unit cost of production � $.75 (� $2 � $112.5/300).(c) New per unit production cost � $1.13. The AS curvewould shift leftward. The price level would rise and real output would decrease.(d) New per unit cost of production � $0.375(�$2 �

112.5/600). AS curve shifts to the right; price level declinesand real output increases.

11-7 What effects would each of the following have on aggre-gate demand or aggregate supply? In each case use a diagramto show the expected effects on the equilibrium price level andlevel of real output. Assume that all other things remain constant.

a. A widespread fear of depression on the part of consumersb. A large purchase of U.S. wheat by Russiac. A $1 increase in the excise tax on cigarettesd. A reduction in interest rates at each price levele. A major cut in Federal spending for health caref. The expectation of a rapid rise in the price levelg. The complete disintegration of OPEC, causing oil pricesto fall by one-halfh. A 10 percent reduction in personal income tax ratesi. An increase in labor productivityj. A 12 percent increase in nominal wagesk. Depreciation in the international value of the dollarl. A sharp decline in the national incomes of our westernEuropean trading partnersm. A sizable increase in U.S. immigration.(a) AD curve left(b) AD curve right(c) AS curve left(d) AD curve right(e) AD curve left(f) AD curve right(g) AS curve right(h) AD curve right(i) AS curve right(j) AS curve left(k) AD curve right; AS curve left(l) AD curve left(m) AS curve right.

11-8 Other things being equal, what effect will each of the following have on the equilibrium price level and level of real output:

ANSWERS TO KEY QUESTIONS 287

300

250

200

150

50

AS

AD

0 100 200 300 400 500

Pric

e le

vel

Real domestic output($ billions)

AD1

Question 11-4

11-5 Suppose that the hypothetical economy in question 4 hadthe following relationship between its real domestic output andthe input quantities necessary for producing that level of output:

waL63791_Ans_279-296 6/18/01 2:51 PM Page 287

a. An increase in aggregate demand in the vertical range ofaggregate supplyb. An increase in aggregate supply with no change in ag-gregate demand (assume prices and wages are flexible)c. Equal increases in aggregate demand and aggregate sup-plyd. A reduction in aggregate demand in the horizontal rangeof aggregate supplye. An increase in aggregate demand and a decrease in ag-gregate supplyf. A decrease in aggregate demand in the intermediaterange of aggregate supply(a) Price level rises and no change in real output(b) Price level drops and real output increases(c) Price level does not change, but real output rises(d) Price level does not change, but real output declines(e) Price level increases, but the change in real output is in-determinate(f) Price level may not change, but real output declines (if prices are flexible downward, then output will decline butnot as much as if prices stay high)

CHAPTER TWELVE

12-2 Assume that a hypothetical economy with an MPC of .8is experiencing severe recession. By how much would govern-ment spending have to increase to shift the aggregate demandcurve rightward by $25 billion? How large a tax cut would beneeded to achieve this same increase in aggregate demand?Why the difference? Determine one possible combination of gov-ernment spending increases and tax decreases that would ac-complish this same goal. (See Figure 12-1 for illustration.)

In this problem, the multiplier is 1/.2 or 5 so, the increase ingovernment spending � $5 billion.

For tax cut question, initial spending of $5 billion is still required, but only .8 (� MPC) of a tax cut will be spent. So .8 �

tax cut � $5 billion or tax cut � $6.25 billion. Part of the tax reduction ($1.25 billion) is saved, not spent.

One combination: a $1 billion increase in government spend-ing and a $5 billion tax cut.

12-3 What are government’s fiscal policy options for ending severe demand-pull inflation? Use the aggregate demand-ag-gregate supply model to show the impact of these policies onthe price level. Which of these fiscal policy options do you thinka “conservative” economist might favor? A “liberal” economist?

Options are to reduce government spending, increase taxes,or some combination of both. See Figure 12–2. If the price levelis flexible downward, it will fall. In the real world, the goal is toreduce inflation—to keep prices from rising so rapidly—not toreduce the price level. A “conservative” economist might favorcuts in government spending since this would reduce the size ofgovernment. A “liberal” economist might favor a tax hike, it wouldpreserve government spending programs.

12-7 Define the “full-employment budget” explain its signifi-cance, and state why it may differ from the “actual budget.” Sup-pose the full-employment, noninflationary level of real output isGDP3 (not GDP2) in the economy depicted in Figure 12-3. If theeconomy is operating at GDP2 instead of GDP3, what is the sta-tus of its full-employment budget? Of its current fiscal policy?What change in fiscal policy would you recommend? How wouldyou accomplish that in terms of the G and T lines in the figure?

The full-employment budget (also call standardized) mea-sures what the Federal deficit or surplus would be if the econ-omy reached full-employment level of GDP with existing tax and

288 ANSWERS TO KEY QUESTIONS

spending policies. If the full-employment budget is balanced, thenthe government is not engaging in either expansionary nor con-tractionary policy, even if, for example, a deficit automatically results when GDP declines. The “actual” budget is the deficit orsurplus that results when revenues and expenditures occur overa year if the economy is not operating at full-employment.

Looking at Figure 12-3, if full-employment GDP level wasGDP3, then the full-employment budget is contractionary since asurplus would exist. Even though the “actual” budget has nodeficit at GDP2, fiscal policy is contractionary. To move the econ-omy to full-employment, government should cut taxes or increasespending. You would raise G line or lower T line or combinationof each until they intersect at GDP3.

12-10 Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy. Explain the notion of a polit-ical business cycle. What is the crowding-out effect and why is itrelevant to fiscal policy? In what respect is the net export effectsimilar to the crowding-out effect?

It takes time to ascertain the direction in which the economyis moving (recognition lag), to get a fiscal policy enacted into law(administrative lag); and for the policy to have its full effect onthe economy (operational lag). Meanwhile, other factors maychange, rendering inappropriate a particular fiscal policy. Never-theless, discretionary fiscal policy is a valuable tool in prevent-ing severe recession or severe demand-pull inflation.

A political business cycle is the concept that politicians aremore interested in reelection than in stabilizing the economy.Before the election, they enact tax cuts and spending increasesto please voters even though this may fuel inflation. After theelection, they apply the brakes to restrain inflation; the economywill slow and unemployment will rise. In this view the politicalprocess creates economic instability.

The crowding-out effect is the reduction in investment spend-ing caused by the increase in interest rates arising from an in-crease in government spending, financed by borrowing. The increase in G was designed to increase AD but the resulting increase in interest rates may decrease I. Thus the impact of theexpansionary fiscal policy may be reduced.

The next export effect also arises from the higher interestrates accompanying expansionary fiscal policy. The higher inter-est rates make U.S. bonds more attractive to foreign buyers. Theinflow of foreign currency to buy dollars to purchase the bondsdrives up the international value of the dollar, making importsless expensive for the United States, and U.S. exports more ex-pensive for people abroad. Net exports in the United States de-cline, and like the crowding-out effect, diminish the expansionaryfiscal policy.

CHAPTER THIRTEEN

13-4 What are the components of the M1 money supply? Whatis the largest component? Which of the components is legal tender? Why is the face value of a coin greater than its intrinsicvalue? What near-monies are included in M2 money supply?What distinguishes the M2 and M3 money supplies?

M1 � currency (in circulation) � checkable deposits. Thelargest component of M1 is checkable deposits. If the face valueof a coin were not greater than its intrinsic (metallic) value, peo-ple would remove coins from circulation and sell them for theirmetallic content. M2 � M1 � noncheckable savings deposits �

money market deposit accounts � small time deposits moneymarket mutual fund balances. M3 � M2 � large time deposits(those of $100,000 or more). Near-monies are components ofM2 not included in M1.

waL63791_Ans_279-296 6/18/01 2:51 PM Page 288

13-6 Suppose the price level and value of the dollar in year 1are 1.0 and $1.00, respectively. If the price level rises to 1.25 inyear 2, what is the new value of the dollar? If instead the pricelevel had fallen to .50, what would have been the value of thedollar? What generalization can you draw from your answer?

In the first case, the value of the dollar (in year 2, relative toyear 1) is $.80 (� 1/1.25); in the second case the value is $2 (�1/.50). Generalization: The price level and the value of the dollarare inversely related.

13-7 What is the basic determinant of (a) the transactions demand and (b) the asset demand for money? Explain how thesetwo demands might be combined graphically to determine totalmoney demand. How is the equilibrium interest rate in the moneymarket determined? How might (a) the expanded use of creditcards, (b) a shortening of worker pay periods, and (c) an increasein nominal GDP each independently affect the transactions demand for money and the equilibrium interest rate?

(a) The level of nominal GDP.The higher this level, the greaterthe amount of money demanded for transactions. (b) The inter-est rate. The higher the interest rate, the smaller the amount ofmoney demanded as an asset.

On a graph measuring the interest rate vertically and theamount of money demanded horizontally, the two demands forthe money curves can be summed horizontally to get the totaldemand for money. This total demand shows the total amount ofmoney demanded at each interest rate. The equilibrium interestrate is determined at the intersection of the total demand formoney curve and the supply of money curve.

(a) Expanded use of credit cards: transaction demand formoney declines; total demand for money declines; interest ratefalls. (b) Shortening of worker pay periods: transaction demandfor money declines; total demand for money declines; interestrate falls. (c) Increase in nominal GDP: transaction demand formoney increases; total demand for money increases; interest raterises.

CHAPTER FOURTEEN

14-2 Why are commercial banks required to have reserves? Explain why reserves are an asset to commercial banks but a liability to the Federal Reserve Banks.What are excess reserves?How do you calculate the amount of excess reserves held by abank? What is their significance?

Reserves provide the Fed a means of controlling the moneysupply. It is through increasing and decreasing excess reservesthat the Fed is able to achieve a money supply of the size it thinksbest for the economy.

Reserves are assets of commercial banks because thesefunds are cash belonging to them; they are a claim the com-mercial banks have against the Federal Reserve Bank. Reservesdeposited at the Fed are a liability to the Fed because they arefunds it owes; they are claims that commercial banks haveagainst it.

Excess reserves are the amount by which actual reserves ex-ceed required reserves: Excess reserves: Excess reserves � ac-tual reserves — required reserves. Commercial banks can safelylend excess reserves, thereby increasing the money supply.

14-4 “When a commercial bank makes loans, it creates money;when loans are repaid, money is destroyed.” Explain.

Banks add to checking account balances when they makeloans; these checkable deposits are part of the money supply.People pay off loans by writing checks; checkable deposits fall,meaning the money supply drops. Money is “destroyed.”

14-8 Suppose the Continental Bank has the simplified balancesheet that follows. The reserve ratio is 20 percent.

Liabilitiesand net

Assets worth(1) (2) (1) (2)

Reserves $22,000 ____ ____ Demand ____ ____

Securities 38,000 ____ ____ deposits

Loans 40,000 ____ ____$100,000

a. What is the maximum amount of new loans which thisbank can make? Show in column 1 how the bank’s balancesheet will appear after the bank has loaned this additionalamount.b. By how much has the supply of money changed? Explain.c. How will the bank’s balance sheet appear after checksdrawn for the entire amount of the new loans have beencleared against this bank? Show this new balance sheet incolumn 2.d. Answer questions a, b, and c on the assumption that thereserve ratio is 15 percent.(a) $2,000. Column 1 of Assets (top to bottom): $22,000;$38,000; $42,000. Column 1 of Liabilities: $102,000.(b) $2,000. The bank has lent out its excess reserves, creating $2,000 of new demand-deposit money.(c) Column 2 of Assets (top to bottom): $20,000; $38,000;$42,000. Column 2 of Liabilities; $100,000.(d) $7,000.

14-13 Suppose the simplified consolidated balance sheetshown below is for the commercial banking system. All figuresare in billions. The reserve ratio is 25 percent.

Liabilitiesand net

Assets worth(1) (2)

Reserves $ 52 Demand deposits $200

Securities 48

Loans 100

a. What amount of excess reserves does the commercialbanking system have? What is the maximum amount thebanking system might lend? Show in column 1 how the consolidated balance sheet would look after this amount hasbeen lent. What is the monetary multiplier?b. Answer question 13a assuming that the reserve ratio is 20 percent. Explain the resulting difference in the lendingability of the commercial banking system.(a) Required reserves � $50 billion (� 25% of $200 billion);so excess reserves � $2 billion (� $52 billion � $50 billion).Maximum amount banking system can lend � $8 billion (�1/.25 � $2 billion). Column (1) of Assets data (top to bottom):$52 billion; $48 billion; $108 billion. Column (1) of Liabilitiesdata: $208 billion. Monetary multiplier � 4 (� 1/.25).(b) Required reserves � $40 billion (� 20% of $200 billion);so excess reserves � $12 billion (� $52 billion � $40 billion).Maximum amount banking system can lend � $60 billion (�1/.20 � $12 billion). Column (1) data for assets after loans(top to bottom); $52 billion; $48 billion; $160 billion. Column(1) data for liabilities after loans: $260 billion. Monetary mul-tiplier � 5 (� 1/.20). The decrease in the reserve ratio increases the banking system’s excess reserves from $2 billion to $12 billion and increases the size of the monetarymultiplier from 4 to 5. Lending capacity becomes 5 � $12 �

$609 billion.

ANSWERS TO KEY QUESTIONS 289

waL63791_Ans_279-296 6/18/01 2:51 PM Page 289

CHAPTER FIFTEEN

15-2 In the table below you will find simplified consolidated bal-ance sheets for the commercial banking system and the twelveFederal Reserve Banks. In columns 1 through 3, indicate howthe balance sheets would read after each transaction of a to cis completed. Do not cumulate your answers; that is, analyzeeach transaction separately, starting in each case from the figures provided. All accounts are in billions of dollars.

Consolidated Balance Sheet: All Commercial Banks

(1) (2) (3)

Assets:Reserves $ 33Securities 60Loans 60

Liabilities and net worth:Checkable deposits 150Loans from the Federal

Reserve Banks 3

Consolidated Balance Sheet:Twelve Federal Reserve Banks

(1) (2) (3)

Assets:Securities $60Loans to commercial banks 3

Liabilities and net worth:Reserves of commercial banks $33Treasury deposits 3Federal Reserve Notes 27

a. Suppose a decline in the discount rate prompts commer-cial banks to borrow an additional $1 billion from the FederalReserve Banks. Show the new balance-sheet figures in col-umn 1.b. The Federal Reserve Banks sell $3 billion in securities tothe public, who pay for the bonds with checks. Show the newbalance-sheet figures in column 2.c. The Federal Reserve Banks buy $2 billion of securitiesfrom commercial banks. Show the new balance-sheet figuresin column 3.d. Now review each of the above three transactions, askingyourself these three questions: (1) What change, if any, tookplace in the money supply as a direct and immediate resultof each transaction? (2) What increase or decrease in com-mercial banks’ reserves took place in each transaction? (3)Assuming a reserve ratio of 20 percent, what change in themoney-creating potential of the commercial banking systemoccurred as a result of each transaction?(a) Column (1) data, top to bottom: Bank Assets: $34, 60, 60;Liabilities: $150, 4; Fed Assets: $60, 4; Liabilities: $34, 3, 27.(b) Column (2) data: Bank Assets: $30, 60, 60; Liabilities:$147, 3; Fed Assets: $57, 3, 30, 3, 27.(c) Column (3) data (top to bottom): $35; $58; $60; $150; $3;(Fed banks) $62; $3; $35; $3; $27.(d) (d1) Money supply (checkable deposits) directly changesonly in (b), where it decreases by $3 billion; (d2) See balancesheets; (d3) Money-creating potential of the banking systemincreases by $5 billion in (a); decreases by $12 billion in (b)(not by $15 billion—the writing of $3 billion of checks by thepublic to buy bonds reduces demand deposits by $3 billion,thus freeing $0.6 billion of reserves. Three billion dollars minus $0.6 billion equals $2.4 billion of reduced reserves, and

this multiplied by the monetary multiplier of 5 equals $12 billion); and increases by $10 billion in (c).

15-3 Suppose that you are a member of the Board of Gover-nors of the Federal Reserve System. The economy is experi-encing a sharp and prolonged inflationary trend. What changesin (a) the reserve ratio, (b) the discount rate, and (c) open-mar-ket operations would you recommend? Explain in each case howthe change you advocate would affect commercial bank reserves,the money supply, interest rates, and aggregate demand.

(a) Increase the reserve ratio. This would increase the sizeof required reserves. If the commercial banks were fullyloaned up, they would have to call in loans. The money supply would decrease, interest rates would rise, and aggre-gate demand would decline.(b) Increase the discount rate. This would decrease com-mercial bank borrowing from the Fed. Actual reserves of the commercial banks would fall, as would excess reservesand lending. The money supply would drop, interest rateswould rise, and aggregate demand would decline.(c) Sell government securities in the open market. Buyers ofthe bonds would write checks to the Fed on their demand deposits. When these checks cleared, reserves would flowfrom the banking system to the Fed. The decline in reserveswould reduce the money supply, which would increase interest rates and reduce aggregate demand.

15-4 What is the basic objective of monetary policy? State thecause-effect chain through which monetary policy is made effective. What are the major strengths and weaknesses of mon-etary policy?

The basic objective of monetary policy is to assist the econ-omy in achieving a full-employment, non-inflationary level of total output. Changes in the money supply affect interest rates,which affect investment spending and therefore aggregate de-mand.

The major strengths of monetary policy are its speed and flex-ibility compared to fiscal policy, the Board of Governors is some-what removed from political pressure, and its successful recordin preventing inflation and keeping prices stable. The Fed is givensome credit for prosperity in the 1990s.

The major weaknesses are that the Fed’s control may weakenwith bank reforms and electronic banking that diminish the im-portance of the traditional money supply, changes in velocity mayoffset changes in money supply and weaken monetary policy results, and monetary policy has asymmetrical impact– it com-bats inflation better than it helps recovery from recession.

15-5 Distinguish between the Federal funds rate and the primeinterest rate. In what way is the Federal funds rate a measure ofthe tightness or looseness of monetary policy? In 1999 and 2000the Fed used open-market operations to increase the Federalfunds rate. What was the logic of those actions? What was theeffect on the prime interest rate?

The Federal funds interest rate is the interest rate bankscharge one another on overnight loans needed to meet the reserve requirement. The prime interest rate is the interest ratebanks change on loans to their most creditworthy customers.Thetighter the monetary policy, the less the supply of excess reservesin the banking system and the higher the Federal funds rate. Thereserve is true of a loose or easy monetary policy which expandsexcess reserves and the federal funds rate will fall.

The Fed wanted to reduce the excess reserves, slowing thegrowth of the money supply. This would slow the expansion ofaggregate demand and prevent inflation. The prime interest ratewent up.

290 ANSWERS TO KEY QUESTIONS

waL63791_Ans_279-296 6/18/01 2:51 PM Page 290

15-6 Suppose the Federal Reserve decides to engage in a tightmoney policy as a way to reduce demand-pull inflation. Use theaggregate demand-aggregate supply model to show what thispolicy is intended to accomplish in a closed economy. Now introduce the open economy and explain how changes in the international value of the dollar might affect the location of youraggregate demand curve.

The intent of a tight money policy would be shown as a leftward shift of the aggregate demand curve and a decline inthe price level (or, in the real world, a reduction in the rate of inflation). In an open economy, the interest rate hike resultingfrom the tight money policy would entice people abroad to buyU.S. securities. Because they would need U.S. dollars to buythese securities, the international demand for dollars would rise,causing the dollar to appreciate. Net exports would fall, pushingthe aggregate demand curve farther leftward than in the closedeconomy.

CHAPTER SIXTEEN

16-3 Suppose the full-employment level of real output (Q) fora hypothetical economy is $250 and the price level (P) initially is100. Use the short-run aggregate supply schedules below to answer the questions which follow:

AS(P�100) AS(P�125) AS(P�75)P Q P Q P Q

125 280 125 250 125 310

100 250 100 220 100 280

75 220 75 190 75 250

a. What will be the level of real output in the short run if theprice level unexpectedly rises from 100 to 125 because of anincrease in aggregate demand? What if the price level fallsunexpectedly from 100 to 75 because of a decrease in aggregate demand? Explain each situation, using numbersfrom the table.b. What will the level of real output be in the long run whenthe price level rises from 100 to 125? When it falls from 100to 75? Explain each situation.c. Show the circumstances described in parts a and b ongraph paper, and derive the long-run aggregate supply curve.(a) $280; $220. When the price level rises from 100 to 125[in aggregate supply schedule AS(P100)], producers experi-ence higher prices for their products. Because nominal wagesare constant, profits rise and producers increase output toQ � $280. When the price level decreases from 100 to 75,profits decline and producers adjust their output to Q � $75.These are short-run responses to changes in the price level.(b) $250; $250. In the long run, a rise in the price-level to125 leads to nominal wage increases. The AS(P100) sched-ule changes to AS(P125) and Q returns to $250, now at a price level of 125. In the long run, a decrease in price levelto 75 leads to lower nominal wages, yielding aggregate supply schedule AS(P75). Equilibrium Q returns to $250, nowat a price level of 75.(c) Graphically, the explanation is identical to Figure 16-1b.short-run AS: P1 � 100; P2 � 125; P3 � 75; and Q1 � $250;Q2 � $280; and Q3 � $220. Long-run aggregate supply �

Q1 � $250 at each of the three price levels.

16-4 Use graphical analysis to show how each of the followingwould affect the economy first in the short run and then in thelong run. Assume that the United States is initially operating atits full-employment level of output, that prices and wages are

eventually flexible both upward and downward, and that there is no counteracting fiscal or monetary policy.

a. Because of a war abroad, the oil supply to the UnitedStates is disrupted, sending oil prices rocketing upward.b. Construction spending on new homes rises dramatically,greatly increasing total U.S. investment spending.c. Economic recession occurs abroad, significantly reducingforeign purchases of U.S. exports.(a) See Figure 16-4 in the chapter. Short run: The aggregatesupply curve shifts to the left, the price level rises, and realoutput declines. Long run: The aggregate supply curve shiftsback rightward (due to declining nominal wages), the pricelevel falls, and real output increases.(b) See Figure 16-3. Short run: The aggregate demand curveshifts to the right, and both the price level and real output increase. Long run: The aggregate supply curve shifts to theleft (due to higher nominal wages), the price level rises, andreal output declines.(c) See Figure 16-5. Short run: The aggregate demand curveshifts to the left, both the price level and real output decline.Long run: The aggregate supply curve shifts to the right, theprice level falls further, and real output increases.

16-6 Suppose the government misjudges the natural rate of unemployment to be much lower than it actually is, and thus undertakes expansionary fiscal and monetary policy to try toachieve the lower rate. Use the concept of the short-run PhillipsCurve to explain why these policies might at first succeed. Usethe concept of the long-run Phillips Curve to explain the long-runoutcome of these policies.

In the short-run there is probably a tradeoff between unem-ployment and inflation. The government’s expansionary policyshould reduce unemployment as aggregate demand increases.However, the government has misjudged the natural rate and willcontinue its expansionary policy beyond the point of the naturallevel of unemployment. As aggregate demand continues to rise,prices begin to rise. In the long-run, workers demand higherwages to compensate for these higher prices. Aggregate supplywill decrease (shift leftward) toward the natural rate of unem-ployment.

In other words, any reduction of unemployment below the natural rate is only temporary and involves a short-run rise in inflation. This, in turn, causes long-run costs to rise and a decrease in aggregate supply. The end result should be an equi-librium at the natural rate of unemployment and a higher pricelevel than the beginning level. The long-run Phillips curve is thusa vertical line connecting the price levels possible at the naturalrate of unemployment found on the horizontal axis.

CHAPTER SEVENTEEN

17-1 What are the four supply factors of economic growth?What is the demand factor? What is the efficiency factor? Illus-trate these factors in terms of the production possibilities curve.

The four supply factors are the quantity and quality of naturalresources; the quantity and quality of human resources; the stockof capital goods; and the level of technology. The demand factoris the level of purchases needed to maintain full employment.The efficiency factor refers to both productive and allocative efficiency. Figure 18-1 illustrates these growth factors by show-ing movement from curve AB to curve CD.

17-5 Between 1990 and 1999 the U.S. price level rose by about20 percent while its real output increased by about 33 percent.

ANSWERS TO KEY QUESTIONS 291

waL63791_Ans_279-296 6/18/01 2:51 PM Page 291

Use the aggregate demand-aggregate supply model to illustratethese outcomes graphically.

In the graph shown, both AD and AS expanded over the1990–1999 period. Because aggregate supply increased as wellas aggregate demand, the new equilibrium output rose at a fasterpace than did the price level. P2 is 20% above P1 and GDP2 is33% greater than GDP1. Note that it is also possible that in early1990s when unemployment was above natural rate that some ofthe expansion of AD took place in the horizontal portion of AScurve, but that is not the situation depicted here.

than previously which expands market possibilities for both con-sumers and producers who are not very limited by national bound-aries today.

CHAPTER EIGHTEEN

18-1 Assess the potential for using fiscal policy as a stabiliza-tion tool under (a) an annually balanced budget, (b) a cyclicallybalanced budget, and (c) functional finance.

(a) There is practically no potential for using fiscal policy asa stabilization tool under an annually balanced budget. In aneconomic downturn, tax revenues fall. To keep the budget inbalance, fiscal policy would require the government to reduceits spending or increase its tax rates, adding to the deficiencyin spending and accelerating the downturn. If the economywere booming and tax revenues were mounting, to keep thebudget balanced fiscal policy would have to increase gov-ernment spending or reduce taxes, thus adding to the alreadyexcessive demand and accelerating the inflationary pres-sures. An annually balanced budget would intensify cyclicalups and downs.(b) A cyclically balanced budget would be countercyclical, asit should be, since it would bolster demand by lowering taxesand increasing government spending during a recession andrestrain demand by raising taxes and reducing governmentspending during an inflationary boom. However, becauseboom and bust are not always of equal intensity and durationbudget surpluses during the upswing need not automaticallymatch budget deficits during the downswing. Requiring thebudget to be balanced over the cycle may necessitate inap-propriate changes in tax rates or levels of government ex-penditures.(c) Functional finance pays no attention to the balance ofdeficits and surpluses annually or over the cycle. What countsis the maintenance of a noninflationary full-employment levelof spending. Balancing the economy is what counts, not thebudget.

18-3 What are the two main ways the size of the public debt ismeasured. Distinguish between refinancing and retiring the debt.How does an internally held public debt differ from an externallyheld public debt? Contrast the effects of retiring an internally helddebt from an externally held debt.

Two ways of measuring the public debt: (1) measure its absolute dollar size; (2) measure its size as a percentage of GDP.

Refinancing the public debt simply means rolling over out-standing debt—selling “new” bonds to retire maturing bonds.Retiring the debt means purchasing bonds back from those whohold them or paying the bonds off at maturity.

An internally held debt is one in which the bondholders livein the nation having the debt; an externally held debt is one inwhich the bondholders are citizens of other nations. Paying offan internally held debt would involve buying back governmentbonds. This could present a problem of income distribution be-cause holders of the government bonds generally have higherincomes than the average taxpayer. But paying off an internallyheld debt would not burden the economy as a whole—the moneyused to pay off the debt would stay within the domestic econ-omy. In paying off an externally held debt, people abroad coulduse the proceeds of the bonds sales to buy products or other assets from the U.S. However, the dollars gained could be sim-ply exchanged for foreign currency and brought back to theirhome country. This reduces U.S. foreign reserves holdings andmay lower dollar exchange rate.

18-7 Trace the cause-and-effect chain through which financingand refinancing of the public debt might affect real interest rates,

292 ANSWERS TO KEY QUESTIONS

17-6 To what extent have increases in U.S. real GDP resultedfrom more labor inputs? Rearrange the following contributors tothe growth of real GDP in order of their quantitative importance:economies of scale, quantity of capital, improved resource allo-cation, education and training, technological advance.

The U.S. labor force grew by about 2 million workers per yearfor each of the past 25 years and this explains much of the growthin real GDP. Other factors have also been important. Refer toTable 17-1. Factor importance in descending order: (1) Techno-logical advance—the discovery of new knowledge which resultsin the combining of resources in more productive ways. (2) Thequantity of capital. (3) Education and training. (4) Economies ofscale and (5) improved resource allocation.

17-8 Relate each of the following to the New Economy:a. the rate of productivity growthb. information technologyc. increasing returnsd. network effectse. global competitionEach of the above is a characteristic of the New Economy.

The rate of productivity growth has grown substantially due to innovations using microchips, computers, new telecommunica-tions devices, and the Internet. All of these innovations describefeatures of what we call information technology which connectsinformation in all parts of the world with information seekers. Newinformation products are often digital in nature and can be easilyreplicated once they have been developed. The start-up cost ofnew firms and new technology is high, but expanding productionhas a very low marginal cost which leads to economies of scale—firms’ output grows faster than their inputs. Network effects referto a type of economy of scale whereby certain information prod-ucts become more valuable to each user as the number of buy-ers grows. For example, a fax machine is more useful to you whenlots of other people and firms have one; the same is true for com-patible word-processing programs. Global competition is a featureof the New Economy because both transportation and communi-cation can be accomplished at much lower cost and faster speed

waL63791_Ans_279-296 6/18/01 2:51 PM Page 292

private investment, and the stock of capital and economic growth.How might investment in public capital and complementaritiesbetween public and private capital alter the outcome of the cause-effect chain?

Cause and effect chain: Government borrowing to finance thedebt competes with private borrowing and drives up the interestrate; the higher interest rate causes a decline in private capitaland economic growth slows.

However, if public investment complements private invest-ment, private borrowers may be willing to pay higher rates forpositive growth opportunities. Productivity and economic growthcould rise.

CHAPTER NINETEEN

19-1 Use the aggregate demand-aggregate supply model tocompare classical and Keynesian interpretations of (a) the ag-gregate supply curve, and (b) the stability of the aggregate demand curve. Which of these interpretations seems more consistent with the realities of the Great Depression?

(a) Classical economists envisioned the AS curve as beingperfectly vertical.When prices fall, real profits do not decreasebecause wage rates fall in the same proportion. With constantreal profits, firms have no reason to change the quantities ofoutput they supply. Keynesians viewed the AS curve as being horizontal at outputs less than the full-employment out-put and vertical only at full employment. Declines in aggre-gate demand do not change the price level because wagesand prices are assumed to be inflexible downward.(b) Classical economists viewed AD as stable so long as themonetary authorities hold the money supply constant. There-fore inflation and deflation are unlikely. Keynesians viewed theAD curve as unstable—even if the money supply is con-stant—since investment spending is volatile. Decreases in ADcan cause a recession; rapid increases in AD can cause de-mand-pull inflation.(c) The Keynesian view seems more consistent with the factsof the Great Depression; in that period, real output declinedby nearly 40 percent in the United States and remained lowfor a decade.

19-4 Suppose that the money supply and the nominal GDP fora hypothetical economy are $96 billion and $336 billion, respec-tively. What is the velocity of money? How will households andbusinesses react if the central bank reduces the money supplyby $20 billion? By how much will nominal GDP have to fall to restore equilibrium, according to the monetarist perspective?

Velocity � 3.5 or 336/96. They will cut back on their spend-ing to try to restore their desired ratio of money to other items ofwealth. Nominal GDP will fall to $266 billion (� $76 billion re-maining money supply � 3.5) to restore equilibrium.

19-7 Use an AD-AS graph to demonstrate and explain theprice-level and real-output outcome of an anticipated decline inaggregate demand, as viewed by RET economists. (Assume thatthe economy initially is operating at its full-employment level ofoutput.) Then, demonstrate and explain on the same graph theoutcome, as viewed by mainstream economists.

See the graph and the decline in aggregate demand from AD1

to AD2. RET view: The Economy anticipates the decline in theprice level and immediate moves from a to d.

Mainstream view: The economy first moves from a to b andthen to c. In view of historical evidence, the mainstream viewseems more plausible to us than the RET view; only when ag-gregate demand shifts from AD2 to AD1 will full-employment out-put Q1 be restored in the mainstream view.

19-13 Place MON, RET, or MAIN besides the statements thatmost closely reflect monetarist, rational expectations, or main-stream views, respectively.

a. Anticipated changes in aggregate demand affect only theprice level; they have no effect on real output.b. Downward wage inflexibility means that declines in ag-gregate demand can cause long-lasting recession.c. Changes in the money supply M increase PQ; at first onlyQ rises because nominal wages are fixed, but once workersadapt their expectations to new realities, P rises and Q re-turns to its former level.d. Fiscal and monetary policy smooth out the business cycle.e. The Fed should increase the money supply at a fixed annual rate.(a) RET;(b) MAIN;(c) MON;(d) MAIN;(e) MON.

CHAPTER TWENTY

20-4 Below are the hypothetical production possibilities tablesfor New Zealand and Spain.

New Zealand’s production possibilities table (millions ofbushels)

Product Production alternatives

A B C DApples 0 20 40 60Plums 15 10 5 0

Spain’s production possibilities table (millions of bushels)

Product Production alternatives

R S T UApples 0 20 40 60Plums 60 40 20 0

Plot the production possibilities data for each of the two coun-tries separately. Referring to your graphs, answer the following:(a) What is each country’s cost ratio of producing plums and ap-ples. (b) Which nation should specialize in which product? (c)Show the trading possibilities lines for each nation if the actual terms of trade are 1 plum for 2 apples. (d) Suppose theoptimum product mixes before specialization and trade werealternative B in New Zealand and S in Spain. What would begains from specialization and trade?

ANSWERS TO KEY QUESTIONS 293

0

b a

P

P2

P1

Q1Q2Q3

ASLR

Question 19-7

AS1

AD1AD2

d

c

Pri

ce le

vel

Real domestic output

waL63791_Ans_279-296 6/18/01 2:51 PM Page 293

(a) New Zealand’s cost ratio is 1 plum � 4 apples (or 1 apple � 1/4 plum). Spain’s cost ratio is 1 plum � 1 apple (or1 apple � 1 plum). See the graphs.(b) New Zealand should specialize in apples, Spain in plums.(c) See the graphs.(d) Total production before specialization and trade: 40 apples (20 � 20) and 50 plums (10 � 40). After specializa-tion and trade: 60 apples and 60 plums. Gain � 20 applesand 10 plums.

20-6 Refer to Figure 3-5 (Chapter 3). Assume the graph depictsthe U.S. domestic market for corn. How many bushels of corn, if any, will the United States export or import at a world price of $1,$2, $3, $4, and $5? Use this information to construct the U.S. ex-port supply curve and import demand curve for corn. Suppose theonly other corn-producing nation is France, where the domesticprice is $4. Which country will export corn; which will import it?

20-7 Draw a domestic supply and demand diagram for a prod-uct in which the United States does not have a comparative advantage. What impact do foreign imports have on domesticprice and quantity? On your diagram show a protective tariffwhich eliminates approximately one-fourth the assumed imports. What are the price-quantity effects of this tariff to (a) domestic consumers, (b) domestic producers, and (c) foreign exporters? How would the effects of a quota which creates thesame amount of imports differ?

294 ANSWERS TO KEY QUESTIONS

D

SP

Pd

0 Qa Qb Qc Qd Qe Q

Pt

Pw

Pric

e

Quantity

Question 20-7

60

NewZealand

Spain

Question 20-4

Question 20-4

Domesticproductionpossibilities

Tradingpossibilities

0 15 30

App

les

( m

illio

ns o

f bus

hels

)

Plums (millions of bushels)

60

120

Domesticproductionpossibilities

Tradingpossibilities

0 15 60

App

les

( m

illio

ns o

f bus

hels

)

Plums (millions of bushels)

1

2

3

4

Question 20-6

Export supplycurve

Import demandcurve

$5

0 15106 7

Pric

e (p

er b

ushe

l)

Quantity(bushels of corn, thousands)

See the graph. The United States does not have a compara-tive advantage in this product so the world price Pw is below theU.S. domestic price of Pd. Imports will reduce the domestic price,increasing consumption from nontrade Qc to Qe and decreasingdomestic production from Qc to Qa. See the graph. A tariff ofPwPt (a) harms domestic consumers by increasing price from Pwto Pt and decreasing consumption from Qe to Qd; (b) aids domestic producers through the increase in price from Pw to Ptand the expansion of domestic production from Qa to Qb; (c)harms foreign exporters by decreasing exports from QaQe toQbQd.

An import quota of QbQd would have the same effects as the tariff, but there would be no tariff revenues to government fromthese imports; this revenue would effectively go to foreign producers.

20-11 What is the WTO, and how does it relate to internationaltrade? What problems, if any, arise when too many extraneousefforts are tied to efforts to liberalize trade?

The WTO is the World Trade Organization with 138 membernations in 2000. It was established in 1994 by some 120 nations who had been supporters of GATT (General Agree-ment on Trade and Tariffs) which preceded WTO. The organiza-tion promotes reduction in trade barriers and helps to enforce the agreement signed by its nation members.

If too many extraneous issues are tied to efforts to liberalizetrade, the liberalization process is slowed down. For example, tying human rights protection to free trade policies might be avery difficult political process which could take much longer tochange than trade policy.

CHAPTER TWENTY-ONE

21-2 Indicate whether each of the following creates a demandfor, or a supply of, European euros in foreign exchange markets:

a. A U.S. airline firm purchases several Airbus planes assembled in France.b. A German automobile firm decides to build an assemblyplant in South Carolina.c. A U.S. college student decides to spend a year studyingat the Sorbonne.d. An Italian manufacturer ships machinery from one Italianport to another on a Liberian freighter.

At $1: import 15,000. At $2: import 7,000. At $3: no importsor exports. At $4: export 6,000. At $5: export 10,000.

The United States will export corn, France will import it.

waL63791_Ans_279-296 6/18/01 2:51 PM Page 294

e. The United States economy grows faster than the Frencheconomy.f. A United States government bond held by a Spanish cit-izen matures, and the loan is paid back to that person.g. It is widely believed that the Swiss franc will fall in the nearfuture.

A demand for euros is created in (a),(c),(e),(f), and (g) butsee note below for e and g. A supply of francs is created in(b) and (d).

Note: Answer for (e) assumes U.S. demand for Frenchgoods will grow faster than French imports of U.S. goods, (g)assumes some holders of francs will buy euros instead(Switzerland is not in the EU).

21-3 Alpha’s balance of payments data for 2001 are shown be-low. All figures are in billions of dollars. What are (a) the balance of trade, (b) the balance on goods and services, (c) thebalance on current account, and (d) the balance on capital account?Does Alpha have a balance of payments deficit or surplus? Explain.

Merchandise exports �$40

Merchandise imports � 30

Service exports � 15

Service imports � 10

Net investment income � 5

Net Transfers �$10

Foreign purchases of U.S. assets � 10

U.S. purchases of foreign assets � 40

Official reserves � 10

Balance of trade � $10 billion surplus (� exports of goods of$40 billion minus imports of goods of $30 billion). Note: This isgoods balance only-uses harrow definition of trade balance.Balance on goods and services � $15 billion surplus (� $55 billion of exports of goods and services minus $40 billion of im-ports of goods and services). Balance on current account � $20billion surplus (� credits of $65 billion minus debits of $45 bil-lion). Balance on capital account � $30 billion deficit (� Foreignpurchases of assets in the United States of $10 billion minus U.S.purchases of assets abroad of $40 billion). Balance of payments � $10 billion deficit.Therefore, U.S. must export official reserves � $10 billion.

21-6 Explain why the U.S.demand for Mexican pesos is downslop-ing and the supply of pesos to Americans is upsloping. Assuminga system of floating exchange rates between Mexico and the UnitedStates, indicate whether each of the following would cause the Mex-ican peso to appreciate or depreciate:

a. The United States unilaterally reduces tariffs on Mexicanproducts.b. Mexico encounters severe inflation.c. Deteriorating political relations reduce American tourismin Mexico.d. The United States’ economy moves into a severe recession.e. The U.S. engages in a high interest rate monetary policy.f. Mexican products become more fashionable to U.S.consumers.g. The Mexican government encourages U.S. firms to investin Mexican oil fields.h. The rate of productivity growth in the United States diminishes sharply.

The U.S. demand for pesos is downsloping:When the peso depreciates in value (relative to the dollar) the United Statesfinds that Mexican goods and services are less expensive indollar terms and purchases more of them, demanding a

greater quantity of pesos in the process. The supply of pesosto the United States is upsloping: As the peso appreciates invalue (relative to the dollar), U.S. goods and services becomecheaper to Mexicans in peso terms. Mexicans buy more dol-lars to obtain more U.S. goods, supplying a larger quantity ofpesos.

The peso appreciates in (a), (f), (g), and (h) and depreci-ates in (b), (c), (d), and (e).

21-9 Diagram a market in which the equilibrium dollar price of oneunit of fictitious currency Zee is $5 (the exchange rate is $5 � Z1).Then show on your diagram a decline in the demand for Zee.

a. Referring to your diagram, discuss the adjustment options the United States would have in maintaining the exchange rate at $5 � Z1 under a fixed exchange-rate system.b. How would the U.S. balance of payments surplus that iscreated (by the decline in demand) get resolved under a system of flexible exchange rates?See the graph illustrating the market for Zees.

ANSWERS TO KEY QUESTIONS 295

0

ba

$4

$5

Q1Q2

Question 21-10

S

D1

D2

Do

llar

pri

ce o

f o

ne

Zee

Quantity of Zee

(a) The decrease in demand for Zees from D1 to D2 will create a surplus (ab) of Zees at the $5 price. To maintainthe $5 to Z1 exchange rate, the United States must under-take policies to shift the demand-for-Zee curve rightward or shift the-supply-of Zee curve leftward. To increase thedemand for Zees, the United States could use dollars orgold to buy Zees in the foreign exchange market; employtrade policies to increase imports to U.S. from Zeeonia;or enact expansionary fiscal and monetary policies to increase U.S. domestic output and income, thus increasingimports from Zeeonia and elsewhere. Expansionary mone-tary policy could also reduce the supply of Zees: Zeeonscould respond to the lower U.S. interest rates by reducingtheir investing in the United States. Therefore, they wouldnot supply as many Zees to the foreign exchange market.(b) Under a system of flexible exchange rates, the absurplus of Zees (the U.S. balance of payments surplus) willcause the Zee to depreciate and the dollar to appreciate until the surplus is eliminated (at the $4 � Z1 exchange rateshown in the figure) because U.S.would import more from Zeeo-nia and they would buy less from U.S. since Zee’s lost value.

CHAPTER TWENTY-TWO

22-3 Assume a DVC and an IAC presently have real per capitaoutputs of $500 and $5,000 respectively. If both nations have a3 percent increase in their real per capita outputs, by how muchwill the per capita output gap change?

waL63791_Ans_279-296 6/18/01 2:51 PM Page 295

Rise in per capital output gap � $135 (� 3% � $5,000 � 3%� $500).

22-6 Contrast the “demographic transition” view of populationgrowth with the traditional view that slower population growth isa prerequisite for rising living standards in the DVCs.

Demographic transition view: Expanded output and income indeveloping countries will result in lower birthrates and slowergrowth of population. As incomes of primary family members expand, they begin to see the marginal cost of a larger familyexceeding the marginal benefit. The policy emphasis shouldtherefore be on economic growth; population growth will realize.Traditional view: Developing nations should reduce populationgrowth as a first priority. Slow population growth enables thegrowth of per capita income.

22-7 Because real capital is supposed to earn a higher returnwhere it is scarce, how do you explain the fact that most inter-national investment flows to the IACs (where capital is relativelyabundant) rather than to the DVCs (where capital is very scarce)?

Capital earns a higher return where it is scarce, other thingsequal. But, when comparing investment opportunities betweenIACs and DVCs, other things equal. Advanced factors filled withspecialized equipment require a productive work force. IACs haveno abundance of educated, experienced workers; these workersare scarce in DVCs. Also, IACs have extensive public infrastruc-tures which increase the returns on private capital. Example: anetwork of highways makes it more profitable to produce goodswhich need to be widely transported. Finally, investment returnsmust be adjusted for risk. IACs have stable governments and “lawand order,” reducing the risk of capital being “nationalized” or pilfered by organized crime.

22-13 Use Figure 22-2 (changing box labels as necessary) toexplain rapid economic growth in a country such as Chile or SouthKorea.What factors other than those contained in the figure mightcontribute to growth?

To describe countries such as Chile and South Korea, wewould need to change labels on three boxes, leading to a changein the “results” boxes. “Rapid” population growth would changeto “low” rate of population growth; “low” level of saving wouldchange to “high” level of saving; “low” levels of investment inphysical and human capital would change to “high” levels of investment in physical and human capital. These three changeswould result in higher productivity and higher per capita income,which would produce a rising level of demand. Other factors:stable national government; homogeneous population; extensiveinvestment in infrastructure; “will to develop”; strong private incentives.

WEB BONUS CHAPTER

Note: Find this chapter at http://www.mhhe.com/economics/mcconnell15.

Web-5 Use a supply and demand diagram to explain why per-sistent shortages of many consumer goods occurred under cen-

tral planning in the Soviet Union and in prereform China. Whywere black markets common in each country?

See Figure Web-1. Because Russia and China set prices anddid not allow them to change as supply or demand shifted, priceswere below the equilibrium price for most goods and services.When the fixed price, Pf, is below the equilibrium price, Pe, therewill be a shortage since the quantity demanded will exceed thequantity supplied.

Black markets are common where prices are fixed below equi-librium levels. People can buy goods at the fixed governmentprices (or pay off clerks to save such goods to sell to them), andbecause of the shortages at the low fixed price, resell thesegoods at a much higher price to those unable to find the goodsin government stores at the controlled prices. This reselling issaid to occur on the black market.

Web-6 What have been the major components of economic re-form in Russia? What is meant when these reforms are describedas “shock therapy”? How successful has Russia been thus far inits reforms?

Privatization of state-owned businesses; market-determinedprices; promotion of competition; integration with the world econ-omy; and price-level stabilization. These reforms are referred toas shock therapy because they were dramatic and quick ratherthan phased in over many years or decades. Russia’s reform hasnominally privatized much of the economy (but property rightsare still not clearly defined), establishing market-determinedprices, and setting the stage for future prosperity. But the transi-tion has resulted in declining living standards for many and in-creasing income inequality. Also, the government still does nothave a successful program for collecting taxes.

Web-8 Relate each of the following items to the success ofmarket reform in China: (a) leasing farm land, (b) price reform,(c) private rural and urban enterprises, (d) special economiczones, and (e) corporatization of state-owned enterprises.

(a) Leasing of land resulted in individually operated ratherthan collectivized farms; this greatly increased production incentives and boosted farm output.(b) Price reform established market-based prices. Thesehigher-than-government prices provided incentives for enter-prises to expand output; they also enabled market-determinedallocation of resources to replace inefficient central planning.(c) Private rural and urban enterprises absorbed workers re-leased by greater productivity in China’s agricultural sector andestablished competition for China’s state-owned enterprises.(d) The special economic zones—with their private corpora-tions, free trade, and foreign investment—established theworkability and benefits of “near-capitalism.”(e) Corporatization focused the goals of state-owned enter-prises on providing high-quality, minimum per-unit cost goodsdesired by consumers.

296 ANSWERS TO KEY QUESTIONS

waL63791_Ans_279-296 7/3/01 6:59 AM Page 296